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Short Selling (Page 105-106)

Short selling involves selling securities
you do not own
Chapter 5 Your broker borrows the securities
Determination of Forward and from another client and sells them in
Futures Prices the market in the usual way

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Short Selling (continued) Example

At some stage you must buy the You short 100 shares when the price is $100 and
securities so they can be replaced in the close out the short position three months later
account of the client when the price is $90
You must pay dividends and other During the three months a dividend of $3 per
benefits the owner of the securities share is paid
receives What is your profit? Short sell at $100-90=10,
There may be a small fee for borrowing pay dividend (3) and any premium 7x100=700
the securities What would be your loss if you had bought 100
shares? Made a loss of 1000 on assets
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The Forward Price Pricing an Investment Asset that

If the spot price of an investment asset is S0 and Provides a Known Income (page 110,
the futures price for a contract deliverable in T equation 5.2)
years is F0, then
F0 = S0erT
where r is the T-year risk-free rate of interest.
F0 = (S0 I )erT
In our examples, S0 =40, T=0.25, and r=0.05 so where I is the present value of the income
that during life of forward contract
F0 = 40e0.050.25 = 40.50

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When an Investment Asset Provides
a Known Yield (Page 112, equation 5.3)
F0 = S0 e(rq )T
where q is the average yield during the life
of the contract (expressed with continuous
compounding)
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Copyright John C. Hull 2014
Valuing a Forward Contract
(pages 112-114)
By considering the difference between a
contract with delivery price K and a contract
with delivery price F0 we can deduce that:
the value of a long forward contract is
(F0 K )erT
the value of a short forward contract is
(K F0 )erT
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Copyright John C. Hull 2014
Stock Index (Page 115-117)
Can be viewed as an investment asset paying a
dividend yield (q=.025) is calculated as the
average yield on the portfolio represented by the
index during life of contract (T=.5)
The futures price and spot price relationship is
therefore
F0 = S0 e(rq )T
where S0 = 5000 and r=.05
F0 = 5000e(.025 )/2 = 5062.89
times 10 per point is portfolio of 50628.9
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19/02/2017
Valuing a Forward Contract
A forward contract is worth zero (except for
bid-offer spread effects) when it is first
negotiated
Later it may have a positive or negative value
Suppose that K is the delivery price and F0 is
the forward price for a contract that would be
negotiated today
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Forward vs Futures Prices
When the maturity and asset price are the same, forward
and futures prices are usually assumed to be equal.
(Eurodollar futures are an exception)
In theory, when interest rates are uncertain, they are
slightly different:
A strong positive correlation between interest rates and the asset
price implies the futures price is slightly higher than the forward
price
A strong negative correlation implies the reverse
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Stock Index (continued)
For the formula to be true it is important that
the index represent an investment asset
In other words, changes in the index must
correspond to changes in the value of a
tradable portfolio
The Nikkei index viewed as a dollar number
does not represent an investment asset (See
Business Snapshot 5.3, page 116)
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Index Arbitrage Index Arbitrage

(continued)
When F0 > S0 e(r-q)T an
arbitrageur buys the Index arbitrage involves simultaneous trades
stocks underlying the index and sells futures in futures and many different stocks
When F0 < S0e(r-q)T an arbitrageur buys futures Very often a computer is used to generate the
trades
and shorts or sells the stocks underlying the
Occasionally simultaneous trades are not
index
possible and the theoretical no-arbitrage
relationship between F0 and S0 does not hold
(see Business Snapshot 5.4 on page 117)

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Futures and Forwards on Futures and Forwards on

Currencies (Page 117-120) Currencies continued
A foreign currency is analogous to a The is worth $1.5
security providing a yield The continuous dividend yield is the foreign
The yield is the foreign risk-free interest risk-free interest rate rf = 0.005
rate The rate for the UK is r=.0075
It follows that if rf is the foreign risk-free The Futures price for the , 6 months ahead is:
interest rate ( r r )T
( r rf ) T F0 S 0 e f 1.5e (.0075 .005) / 2
F0 S 0 e
1.5e (.00125) 1.5019
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Copyright John C. Hull 2014 15 John C. Hull 2005 8.16

Explanation of the Relationship Consumption Assets: Storage is

Between Spot and Forward (Figure 5.1) Negative Income
F0 S0 e(r+u )T
1000 units of where u is the storage cost per unit time as a
foreign currency
(time zero) percent of the asset value.
r T
Alternatively,
1000 e f units of
1000S0 dollars
foreign currency
at time T
at time zero F0 (S0+U )erT
where U is the present value of the storage
r T
1000S0erT
costs.
1000 F0 e f
dollars at time T dollars at time T

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Futures Prices & Expected Future

The Cost of Carry (Page 123)
Spot Prices (Page 124-126)
The cost of carry, c, is the storage cost plus Suppose k is the expected return required by
the interest costs less the income earned investors in an asset
We can invest F0er T at the risk-free rate and enter
For an investment asset F0 = S0ecT
into a long futures contract to create a cash inflow of
For a consumption asset F0 S0ecT ST at maturity
The convenience yield on the consumption This shows that
asset, y, is defined so that F0 e rT e kT E ( ST )
F0 = S0 e(cy )T or
F0 E ( ST )e ( r k )T
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Futures Prices & Future Spot

Prices (continued)
Testing Efficiency(Future/Forwards)
A regression of F on S:
No Systematic Risk k=r F0 = E(ST) St Ft T t
Positive Systematic Risk k>r F0 < E(ST) where E(t s ) 0, 0 and =1.
Negative Systematic Risk k<r F0 > E(ST) Problems with this form of analysis:
a) The Financial Data follow random walks
b) It is very unusual to find uncorrelated errors
Positive systematic risk: stock indices
Negative systematic risk: gold (at least for some periods) Tests of =0 and =1 were ill-formulated as the
models serially correlated so tests wrong.
Options, Futures, and Other Derivatives, 9th Edition, Options, Futures, and Other Derivatives 6th Edition, Copyright
Copyright John C. Hull 2014 21 John C. Hull 2005 8.22

Testing Continued Findings

Test efficiency by determining whether St - Ft has Often futures contracts are traded continuously, but
bounded variation (stationary) reported data (see DataStream) for more than one
Imposes the restriction of St on Ft (=0 and =1). contract.
Test an effectively functioning market, using t-value Often analysis done for 1-6 months before
on the restricted regression on et =St Ft: expiration and efficiency/stationarity is rejected for
3-6 months before expiration.
et et 1 errort
Compare t-value on by a one sided test that is
less than -2.89 (T=100).
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Futures in Medieval times Developed into Exchange trading

From 1100 trades were undertaken in medieval
fairs on a spot basis
A lettre de faire was a forward contract spe-cifying
delivery of a good at a later date.
The contracts were often seasonal around harvests
Irregularity meant no formal market so are these
are derivative markets?
Options, Futures, and Other Derivatives 6th Edition, Copyright
John C. Hull 2005
The Royal Exchange in London is the first recorded
as permitting forward contracting.
1610-1611 records of future and forward contracts
in Holland and tulip bulbs were bought forward to
secure supply for the producers (tulip bulb mania or
bubble).
1650 Futures contracts can be traced to the
Yodoya rice market in Osaka.
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